Are Local Asset Management Companies Solutions to China's bad loans?

Many locallocal government investment projects initiated since 2008 — largely at the insistence of Beijing to minimize the impact of the global financial crisis — are likely to be financially unviable. The same applies to a significant share of investment projects launched over the same period by state-owned enterprises.

Whenever investments fail to yield adequate financial returns to service debt obligations, the question arises: Who is going to foot the bill?

Cleaning house

The cleanup process is likely to start this year, from the bottom up. Provinces are setting up and arranging funding for asset management companies that will buy bad assets from local governments, banks and trust companies.

Many local governments set up special-purpose off-balance-sheet entities, often referred to as local government financing vehicles, to fund projects. The price that an asset management company pays for the distressed assets of one of these vehicles will determine how much loss will have to be absorbed by that vehicle’s creditors, mainly banks and so-called shadow banks.

Late last year, the China Banking Regulatory Commission set guidelines for the corporate structure of new asset management companies, stipulating that each must have a minimum of 1 billion yuan ($160 million) in capital. These companies will fund themselves by issuing debt that is likely to be guaranteed in some fashion by the central government.

Local asset management companies will add competition and margin pressure to the four state-owned national bad loan managers — Cinda, Huarong, Great Wall and OrientOrient Asset Management — in bidding for toxic assets.

These “big four” were set up in 1999 to take over nonperforming loans from major banks. Rather than winding up operations after those bad debts were restructured, the four companies have been commercialized, with Cinda even launching a $2.5 billion initial public offering on the Hong Kong stock exchange in December.

The new regional companies would have the advantage of strong local connections and knowledge of the communities, but whether they will be as successful as their national counterparts is anybody’s guess.

In the absence of details, it is hard to know how losses will be distributed between lenders and borrowers. Deep discounts cannot be excluded, and neither can the possibility that smaller financing vehicles may be allowed to go bankrupt.

The only entity with truly deep pockets in China is the central government and by extension the People’s Bank of ChinaBank of China, the central bank. The central government has low debt — just slightly over 20% of gross domestic product — and significant capacity to raise taxes.

Picking and choosing

Will the central government bail out local authorities that sponsored unviable projects or the banks that lent to them?

Financing vehicles, created to get around a ban on bond issuance or direct borrowing by local governments, have created an unstable chain of lending that now threatens to implode. If a local authority is allowed to default on its debt guarantees, banks and shadow banking lenders that lent to its financing vehicle are likely to face solvency challenges, with implications for their shareholders, creditors and, ultimately, their depositors.

Thus, a transfer of local government liabilities — implicit and off-balance-sheet — to the central government is imminent. But how China will go about this transfer is yet to be seen. It is highly likely that the position of senior unsecured creditors and depositors will be guaranteed by the Chinese central government. Beyond these “untouchable” few, it is unclear who will pay the bill for failed local government and investment projects.

The central government’s choice of method matters. It could bail out local governments or their financing vehicles directly, providing them with the resources to service their loans from both the banking and shadow banking sectors. In that case, the lenders would remain whole.

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